The risks from the unending banking mess

The harsh fact is that no country with a broken banking system can hope to grow rapidly

The only stakeholders who have maintained their confidence in the Indian banking system till now have been depositors. Illustration: Jayachandran/Mint

Here is a statistic to ponder over. Nineteen Indian banks are being traded at large discounts to their book value in the stock market. This essentially means that investors have little trust in the published accounts of these lenders. The Reserve Bank of India (RBI) does not seem to have much confidence in many of the weakest banks either. Eleven of them have in effect been told to stop giving fresh loans. Credit rating agency Fitch has said in its recent note on ICICI Bank that the allegations about conflicts of interest could create reputational risks in the future. This is a more general truth for the troubled Indian banking sector as a whole.

The only stakeholders who have maintained their confidence in the Indian banking system till now have been depositors. They have thankfully held their nerve despite the daily flow of negative information about the banks they put their life savings in. There are only minimal chances that India could face a run on banks, as happens in countries with full-blown banking crises. One reason is the public view that there is an implicit sovereign guarantee to back banks. However, it is also important to remember that panic can spread with blinding speed in our times, when just about everyone has access to messaging services such as WhatsApp.

The current banking mess has not become a generalized loss of confidence—and there are few reasons right now to believe that matters will deteriorate to an extent where depositors begin to worry about the safety of their money. Yet, there can be no doubt that the revelations over the past three years, ever since the Indian central bank forced asset quality reviews, have hurt the reputation of the Indian banking system as a whole. There has been a lot of heated debate about what went wrong in the first place. There is also a lot of angry discussion about who is responsible. These are important issues, but the government also needs to focus its attention on what comes next.

The ongoing Indian banking mess calls for a radical overhaul of the system. We have earlier in these columns argued that India needs a new banking policy framework if the mistakes of the past are not to be repeated. There have been three previous attempts—the report of the first committee headed by M. Narasimham in 1991, the report of the second Narasimham committee in 1998 and the report of the committee headed by Raghuram Rajan in 2009. It is now time for a fourth attempt.

There are four important issues that need to be addressed.

First, there is the issue of ownership. The ongoing problems at ICICI Bank and Axis Bank show that private sector banks are not immune from the problems of bad lending, but have generally done better than public sector banks when it comes to asset quality. The case for a banking system with more private sector participation continues to be a strong one.

Second, there needs to be more clarity on the structure of Indian banking. The first Narasimham committee had recommended that India should have three tiers—around four banks with international presence, about eight banks with national presence, and then many local banks. Indian banking after 1998 went towards universal banks. It is time to look at a more diverse banking structure, especially specialized institutions that have access to long-term money as well as project analysis capabilities to assess large infrastructure projects of the type that are now creating havoc in bank balance sheets.

Third, policymakers need to decide what role bond markets will play in the Indian financial system. It is worth asking whether the bond markets would have been as ready to accommodate over-leveraged companies, compared to the enthusiasm shown by bankers to either evergreen or restructure loans. This newspaper has often argued that India should move to a financial system in which large companies get their funds from the corporate bond market while smaller companies depend on banks for their funding.

India is in the midst of its third banking mess in three decades. The after-effects of a credit bubble as well as episodes of regulatory forbearance have meant that those in charge of financial stability had kicked the can down the road till very recently. This is the time to look ahead to a new policy framework. The harsh fact is that no country with a broken banking system can hope to grow rapidly, in effect compromising the battle against poverty. That is the real cost of inefficient banking.

What should policymakers do to make banking more efficient in India? Tell us at views@livemint.com